Clearer lines drawn for Telstra

Telstra
continued its unlikely run as the big-cap stockmarket star of 2011 this week after shareholders gave their blessing to its hotly anticipated $11 billion deal with the Gillard government.

After three years of regulatory uncertainty and jangled nerves over the company’s future, its 1.4 million investors expressed relief that they can look forward to two more years of market-leading dividend payout.

There is still some uncertainty as the Australian Competition and Consumer Commission must give the nod to the deal, in which Telstra hands over its fixed-line monopoly to Labor’s national broadband network within the next decade.

But as expectations rise that sizeable share buybacks will follow soon after Telstra (most likely) gives some ground to the ACCC and gets approval, income investors are increasingly enthusiastic about prospects for the nation’s most widely held share.

Whether the stock can break out of the $2.60 to $3.50 range it has been locked in for the past three years remains to be seen.

Perpetual head of equities Matt Williams says Telstra is far from a growth stock.

“The confirmation of the 28¢ fully franked dividend for the next two years is very positive and there is now much more regulatory certainty with the NBN process," Williams says.

“So really, I think for the first time in a long time, you can now invest with some certainty in Telstra."

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At the current share price, an investor would get at least at a 9 per cent dividend yield, which grosses up to more than 12 per cent once franking credits are included.

“Given the current state of the market, which is yielding 5.5 per cent, that kind of return alone is fairly attractive," Williams says.

“Any capital growth on top of that would be a bonus but I don’t think you can count on that because the company is still under pressure with its PSTN business [traditional fixed-line phone services], the Sensis [Yellow Pages] business and fully fledged competition in broadband in particular."

Investors luckily enough to picked the bottom and bought in at $2.56 in November last year are already sitting on sizeable gains.

Chairman
Catherine Livingstone
noted this week that the shares had outperformed the market by 25 per cent over the past 12 months and more than held their value amid the turmoil of the past six months.

That’s small comfort for anyone who bought stock at the $3.50 mark it was trading at before Telstra was ejected from Labor’s original NBN plans in late 2008 – which sparked the row that ultimately led to this week’s deal.

Indeed, the vast majority of investors are well underwater, including all those who bought their shares in the T1, T2 and T3 privatisations.

Nevertheless Williams sees the possibility of more upside.

“There is a possibility that it gets re-rated to an 8 per cent yield, particularly if we get interest rate cuts," he says.

“An 8 per cent yield would translate into a share price of $3.50 and I don’t think that’s totally inconceivable. We are always looking for the two- to three-year time frame."

One retail shareholder voiced the frustration of many others at Tuesday’s annual meeting saying, albeit inaccurately, that they had been forced by the government to sell the company back at a cheaper price than they bought it for.

Neither Telstra nor its shareholders are selling any assets. Telstra will rent infrastructure and transfer customers to NBN Co, the company building the NBN, in return for payments worth $9 billion in today’s money, staggered over 10 to 30 years. It will also be relieved of regulatory obligations by the government, worth $2 billion in today’s money.

Critically, the company will not have to invest in its ageing copper and cable networks to compete with NBN Co, which was the ugly alternative it faced if shareholders voted down the deal.

That has helped give the company the confidence to maintain the dividend payout.

The dividend is covered by cash earnings, helped by capital expenditure being lower than it was under former chief executive Sol Trujillo, who splurged $20 billion on a massive transformation project with mixed results.

Royal Bank of Scotland’s Ian Martin believes Telstra can still pay the dividend and keep investing at its current rate.

“A 28¢ dividend is not a constraint in [financial year 2012] or FY13, and probably not for several years if at all through the NBN rollout," he says.

“It would only be a constraint if a major new initiative arose that required significant capital, and there is nothing on the horizon."

It is possible the 4G mobile phone spectrum auctions Telstra faces next year could require significant capital but Martin says that could most likely be funded from operating free cash flow while still funding the dividend.

Notably, the shares are currently trading ex-dividend, which implies potential upside as its next dividend date approaches.

Meanwhile significant cash flows are set to come from NBN Co by 2012 and capital management is on the agenda.

Williams disputes suggestions that a major buyback program would be an admission that the Telstra management has run out of investment ideas.

“It would be very difficult for Telstra to break out and make a large-scale acquisition. I don’t think they have a mandate from shareholders to do that."

Chief executive
David Thodey
has identified Asia as a key growth area and Telstra is certainly well behind Optus’s parent, SingTel, in terms of exposure to faster-growing emerging markets.

But IML investment director Anton Tagliaferro believes it is well placed for growth at home, even though it will gradually give up the 60 per cent margins made on the fixed-line network as it is decommissioned.

“Is it a growth stock? It’s certainly operating in a growth sector in terms of mobile and the internet," Tagliaferro says.

“Telstra will be the No. 1 telco in Australia for many years to come and it will grow accordingly. The internet is starting to become part of people’s life.

“The big question now is, how do you monetise that growth."

“What’s next? I think Thodey’s doing a reasonable job in getting the company to focus on customer needs and customers are beginning to notice service is better.